Big Money in Free Seats

Sir Richard Branson was once asked for advice on how to quickly become a millionaire. Simple, he replied: “just start with a billion dollars and then buy an airline.” Airlines are terrible businesses. Between high equipment and labor costs, high fuel prices, and cutthroat competition, they’re almost perfectly designed to go bankrupt. Back in 2002, when United Airlines took its most recent trip to the bankruptcy court, its financial books were opened to the examiners, and they were not pretty. Amazingly, there was just one part of United’s business that made money. Not flying passengers, not shipping cargo – it was their MileagePlus frequent flyer program.

Wait – how in blazes do you make a profit handing out free seats? Well, that’s actually the wrong question. Let’s step back, and consider the larger, more important question: what exactly is a frequent flyer program? Anyone? Bueller? Bueller? Yes, in the back?

It makes more sense to think of a frequent flyer program as an alternate currency. Amazingly, if you counted up all of the miles that have ever been issued by the world’s airlines, you come up with something on the order of 15 trillion miles. Valued at two cents apiece, that would make frequent flyer miles the second most widely-circulated currency in the world, after the U.S. Dollar. From the airline’s perspective, though, there are several major built-in advantages to their currency over the ordinary sawbuck. The Federal Reserve chairman would be green with envy. (Ha! Because money is gree … eh, never mind.) Remember, airlines not only issue this “currency,” they also arbitrarily decide how much of it to create, have total control over how it can be spent, and they can sell it – for a big profit. Let’s examine just how much.

I previously wrote about how credit card companies routinely hand out tons of frequent flyer miles, but just think of all the other ways that you can earn frequent flyer miles: hotel stays, car rentals, flower deliveries, Netflix signups… where’d those companies get all those miles? They bought them from the airline, and not for face value. While the exact price is something the airlines keep pretty close to their chest, an excellent estimate of a FF mile’s “sale price” (based on the airlines’ own annual financial reports) is somewhere around two cents per mile. In other words, when the bank gives you 25,000 bonus miles for hitting that minimum credit card spend, they probably paid the airline around $500 for those 25,000 miles. Hey, not bad, Mr. Airline Marketing Guy! 25,000 miles is a common price for a saver-level domestic roundtrip ticket in Cattle Class, and those usually don’t sell for more than $500. So the airline generated $500 by giving away a free seat …

Hold on, nobody’s actually getting that seat yet. Now we consider another important feature of the frequent flyer mile…it’s perishable. It expires. For as hard as most Mileage Junkies here on the blog chase after miles, to the great majority of the flying public, they’re an afterthought. Somewhere between 17% and 25% of all issued miles are simply forgotten, and disintegrate into nothingness, year after year. Imagine getting paid in $20 bills that had “good until December 2013” printed under Andrew Jackson’s picture. Mile spoilage is predictable enough that an airline can sell a billion frequent flyer miles, and safely assume that around 200 million of them will never get used. The other 800 million will eventually be redeemed – with considerable difficulty.

Ask anyone who’s ever tried to book the family to Disneyland at Christmas, airlines make it pretty challenging to spend those hard-earned miles. You can’t redeem them for just any empty seat on the plane – only the ones that are made available. And when low-cost award seats are available, they’re likely to be on flights that are leaving at inconvenient times in the middle of the week, on flights that usually don’t fill up. Yes, the airlines are selling mileage awards to fill seats that would have gone empty otherwise. Oh, they may release additional seats on more convenient flights – at twice the mileage price or more (I’m looking at you, Delta).

By the airline’s own estimates (as of 2008), when they figure out the total liability of their outstanding frequent flyer miles, they use a valuation of – wait for it – 40 cents per one thousand miles. Yes, that award in the heavenly lie-flat business class seat to Paris, that you shelled out 100,000 miles for, costs the airline a grand total of forty bucks. Well, the price of fuel has gone up in the past four years; it might cost them fifty, now.

So the next time you feel guilty for collecting all those “free” miles, remember that the airlines are making a five thousand percent profit on them. Whoa. Running an airline may be a terrible way to turn a profit, but running a frequent flyer program is a license to print money.

Mile High Canuck
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Sorry but there’s some pretty bad math in this article – I’m not sure where the author got an estimate of 2 cents per mile that the airlines are “selling” to credit card companies, but that is WAY off. Completely off. At that price, you expect us to believe credit card companies are paying $1,000 for 50k signup bonuses, and $2,000 per consumer for 100k signup bonuses.

Just sit back and think about that for a second – let it seep in. Is that even possible? Of course not. If the cost was that high, credit card companies would simply offer consumers $1k cashback on their card after first use. Imagine getting $1,000 for using a credit card ONCE! Yet you expect us to believe that that is what credit card companies are paying airlines for that same scenario? Not a chance. Some basic common sense has to come into play here.

Also, the $40 cost MAY apply if the airline is simply selling a seat that would otherwise go unused. So that’s completely focused on “Saver” type of awards. Most airlines have some sort of standard awards with “no blackouts”, so that $40 doesn’t come into play there.

From an accounting perspective – yes of course it’s absurdly easy to profit on the miles programs. Why? Because there are very little expenses that go into that category. But you have all the income from it. The only expense for mileage programs is simply administration. Jets, fuel, empty seats, food, crew salaries – all that gets expensed elsewhere. So you are always going to show a good profit on miles programs, but just not for the reasons mentioned in this article as the numbers are quite a bit off.

Charles Clarke

I agree that his numbers are off a bit, but he does make some good points on the number of miles that expire and the airlines award seats steering you to the seats that they would be selling cheaply.

Why do you say that the only expense for mileage programs is administration? I would expect that, like most large companies with different departments, the frequent flyer department has to “buy” those tickets(at greatly reduced prices) from the operations department. If they have the miles on the books as a liability of $.4/1000 miles with a 20% expiration rate, then they are expecting to use the unexpired miles at a cost of $.5/1000 used miles. So for your standard award of 50K miles for a domestic flight, they are figuring a cost of $25/flight. Definitely cheap. Maybe the way the frequent flyer programs make money is at the expense of the rest of the airline (or not paying for the seat – as you state)! Has anyone looked into those that are separated off into another company at whether that other company is owned by a select few individuals as opposed to the shareholders in the airlines?

I’m also wondering how much revenue the airline/frequent flyer programs have received because someone signed up for a credit card from the airlines site or direct mail from them. I realize they make money from selling the bank(s) the miles you earn, but I don’t see why they wouldn’t earn a commission like affiliates do if you are coming from their site.

Taking the airlines’ numbers for the value of the unused miles and giving that value to the IRS when you are contesting the “value” placed on any miles you receive a 1099 on would be interesting. Anyone done this?

AKold

I doubt credit card companies pay more than a penny per mile. After all, they buy them in bulk.

gregorygrady

Wow, I was gonna comment on how wrong your “excellent estimate of 2cpm that airlines sell miles to CCs for”, but it looks like the previous commenter wrote exactly what I was gonna write. Please do let us know how you came up with this valuation though based on the airlines financials, as I’m extremely curious.

dt344

Availability for Disneyland around the holidays can be better than you might expect. Disney WORLD, on the other hand, is a whole different story.

Scott

Thats 2 straight posts by the same person who doesn’t seem to know what they’re talking about. First he/she claims credit card churning to be profitable to banks. There’s no way thats possible with how the average reader of mileage blogs spend. especially when applying for new cards every 3 months and normally cancelling/downgrading when the first annual fee is due. now he/she claims banks pay 2 cents per mile? this post seems to directly contradict the math on the previous post.

http://twitter.com/Mileage_Update Mileage Update

My only caveat to this is that most people who get they CC arent mileage freaks. We make up a small minority of the sign ups so I wouldnt use what we normally do for how most CC sign ups act.

http://twitter.com/Mileage_Update Mileage Update

I was gonna say that “The Fed” aint too jealous as they also arbitrarily decides how much money to create.

Daniel Snyder

I for one am very greatful of the effort you put forth to educate us & keep us informed of the opportunities that allow us to travel. Your Blog got me started and in understandable terms, explained the nuances of frugal travel. Thank You Very Much.

Charles Clarke

Are you using these numbers secondhand or have you gotten them straight from the airlines’ financials? If so, which ones?

Thanks!

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